MAYER & RISER, PLLC
ATTORNEYS AT LAW
HIGHLANDS, NORTH CAROLINA
(828) 526-3731
Domestic Asset Protection Planning
Exempt Personal Property and Income
In North Carolina, the following personal property of a debtor is protected:
These exemptions do not protect property from claims of the U.S. government, claims of State or local governments, claims of workmen's and mechanics' liens (as to the property worked on), claims for payment of obligations contracted for the purchase of the specific real property affected, claims related to security interests in specific property, claims for statutory liens, and claims for child support, alimony and equitable distribution.
In North Carolina, a debtor's earnings can be garnished by a creditor. Earnings for the 60 days prior to an execution order are exempt if the earnings are needed to support the debtor's family. Additionally, worker's compensation payments, public assistance payments, unemployment compensation and aid to blind persons are exempt from the claims of creditors.
Homestead laws reflect the public policy that the family home is sacred regardless of the financial condition of the owner. However, most states restrict this protection to rather small amounts of value. In North Carolina, the constitutional homestead protection is limited to $1,000. This is the amount of value exempt from debtors. There is also a statutory exemption for a debtor's interest in real or personal property used as the debtor's residence. Under this exemption, a debtor may protect up to $10,000 of such property from the claims of creditors. A debtor may elect only one or the other protection, either the statutory protection or the constitutional protection.
The statutory homestead exemption does not protect property from claims of the U.S. government, claims of State or local governments for taxes or bonds, claims of workmen's and mechanics' liens (as to the property worked on), claims for payment of obligations contracted for the purchase of the specific real property affected, claims related to security interests in specific property, claims for statutory liens, and claims for child support, alimony and equitable distribution. The constitutional homestead exemption protects property from all claims except claims for taxes or for payment of obligations contracted for the purchase of the specific real property affected.
In North Carolina, a joint tenancy with right of survivorship may be severed by sale under execution against one of the joint tenants. A transfer by gift from one person to that person and another as joint tenants with right of survivorship is a transfer of value from the transferor to the other joint tenant and is therefore subject to fraudulent conveyance claims.
In North Carolina, married persons may own real property as husband and wife as tenants by the entirety. Property held as tenants by the entirety is protected from claims against one of the tenants, but not from claims against both tenants, e.g., where both a husband and wife have signed a contract. Additionally, there is some indication that a tenancy by the entirety may not protect property from the claims of the federal government for taxes owed by one party.
"Qualified retirement plans" - pension plans, profit-sharing plans, annuity plans, etc. described in Sec. 401(a) of the Internal Revenue Code - are protected by the Employee Retirement Income Security Act (ERISA). ERISA requires that retirement plan assets be kept in trust, beyond the reach of an employer's creditors. ERISA also requires qualified plans to prohibit the transfer and assignment of plan benefits, which places the assets beyond the reach of the employee's creditors as well. ERISA does not, however, provide protection for retirement plan benefits after they are distributed to the employee.
North Carolina law protects regular IRAs (but possibly not Roth IRAs) from the claims of creditors. North Carolina also provides protection for the pension and retirement plans of state and local government employees. The law does not, however, provide protection for IRA benefits or state plans after they are distributed. The law does not protect IRAs and state plans from claims of the U.S. government, claims of State or local governments for taxes or bonds, claims of workmen's and mechanics' liens (as to the property worked on), claims related to security interests in specific property, claims for statutory liens, and claims for child support, alimony and equitable distribution.
The North Carolina Constitution protects from the claims of creditors both the lifetime value and the death proceeds of life insurance owned by a debtor that is for the sole use and benefit of his spouse and/or children. North Carolina statutes also protect the lifetime value and the death proceeds of a life insurance policy owned by a debtor but payable to someone other than the debtor or his estate or the insured person or his estate. However, premium payments paid with the intent of defrauding creditors will cause the proceeds attributable to those premiums as well as the lifetime value attributable to those premiums to be reachable by creditors. North Carolina law does not expressly exempt annuities from the claims of creditors.
The corporation is a business entity with a legal existence and identity that is separate from its owners. It is characterized, generally, by a tripartite structure that separates ownership from management and the day-to-day business of the corporation. A corporation's owners (the shareholders) elect a governing body (the board of directors), which oversees the general management of the corporation. The board of directors appoints officers who oversee the day-to-day business of the corporation and have the authority to transact business on behalf of the corporation. Ownership of a corporation is represented by shares of stock.
Often, incorporation is the first means of asset protection considered by business owners. If a corporation is sued or goes bankrupt, the shareholders of the corporation are generally not personally liable for the debts of the corporation. They can only lose what they've invested. However, there are many ways for a plaintiff's lawyer to "pierce" the corporate veil of limited liability, the effect of which is to cause shareholders to be personally liable for corporate debts. In fact, in many lawsuits against small corporations with only one shareholder or a few shareholders, the shareholders are often named as defendants as a matter of course.
A corporation can protect a business owner's personal assets from business
liabilities, but only if the corporation is clearly separate from its
owners. One factor to which courts often look is the maintenance of
corporate records and the adherence to statutorily mandated corporate
decision-making formalities. For example, if the corporation entered into
a financing transaction, did the board of directors vote on the transaction, did
the board of directors authorize the officers to enter into the transaction, was
the meeting and vote properly recorded in the corporate minute book, etc.
The shareholders of a corporation have limited liability for the debts of the corporation. That is, they can only lose what they've invested.
Limited liability for the owners of a corporation does not mean the corporation will not be liable for the actions of its employees nor that a shareholder, officer or director will not be liable for his or her own actions. An owner will be liable for his or her own personal misconduct as well, including negligent hiring and supervision of employees. A shareholder may be personally liable because he or she personally guaranteed a loan or line of credit. Of course, if a shareholder has personally guaranteed a corporate debt, the personal guarantee can cause the shareholder to be personally liable for more than his investment in the corporation. As a practical matter, the major shareholders of small corporations are required to personally guarantee contractual obligations of the corporations.
Limited liability will not apply if the shareholders of a corporation do not treat the business as a separate entity. If the business is grossly undercapitalized, if the owners mix business and personal funds, or if the business fails to keep proper business records, it is possible that a court may find that the corporation is merely the "alter ego" of its owners, and as such the owners of the business will be liable for the debts of the business. This problem is relatively easy to avoid. Simply keep business activities distinctly separate from personal activities.
If all of these bad things can happen, what good is limited liability?
Limited liability protects owners from contractual debts of the company. If the company fails to pay for goods or services, the owners will not be personally liable unless, of course, they personally guaranteed the debt. Limited liability also protects owners from tort liability (injury to others) related to the company to the extent that they were not personally involved in a bad act.
Limited liability also protects business owners from the misdeeds of other owners and employees (absent some claim like negligent hiring or supervision). If one owner or employee is making a delivery and runs over a brain surgeon, the corporation may lose everything, and that owner or employee may lose everything, but the personal assets of the other owners are not at risk. The limited liability offered by corporations is not complete, but it is certainly a valuable feature.
Perhaps the greatest disadvantage to the corporate form as compared to the limited liability company discussed below is that a corporation offers no asset protection to a business owner for debts unrelated to the business. A shareholder's stock is an asset available to satisfy the claims of creditors of the shareholder. For example, Jane operates her retail store as a corporation, Jane's Store, Inc. Jane owns 51% of the stock and her husband, Bob, owns 49% of the stock. Jane and Bob are on vacation and Jane is involved in an automobile accident. Jane is sued, loses, and a judgment of $2 million is entered against her. The policy limit of Jane's insurance coverage was $1 million, a level higher than most, but still not enough to satisfy the plaintiff's claim. The plaintiff executes against Jane's personal assets, including her 51% share Jane's Store, Inc. stock. The plaintiff is now the majority shareholder and will either control the business or, more likely, force a liquidation of the business.
The bottom line: for protecting assets, incorporation is better than nothing, but there is a superior choice - the limited liability company.
Everywhere you turn for information about tax planning, business planning and asset protection planning, you hear about limited liability companies (LLCs). So, what's so special about LLCs? For the first time, U.S. businesses can qualify for unrestricted passthrough taxation and obtain limited liability for their owners.
The limited liability company ("LLC") is a hybrid type of legal entity that combines certain traits normally associated with corporations with other traits normally associated with partnerships and other non-corporate legal entities. LLCs allow their owners (called "members") to have the best of all worlds: passthrough taxation, limited liability, flexibility in ownership and management structure, and personal asset protection.
While corporate statutes are generally written to accommodate the needs of businesses with large numbers of passive stockholders, LLC acts are generally written with small businesses in mind. Thus, the LLC tends to be a more flexible and understandable business entity.
LLCs are managed in one of two general ways:
While a manager of a manager-managed LLC typically is also a member, under the LLC acts of most jurisdictions, a manager need not be a member. So, while a corporation generally is operated with two levels of decision-making (board of directors and officers), an LLC can be operated with only one level of decision-making.
Although the LLC is relatively new in the U.S., the concept has been around for over one hundred years in Europe and Latin America. In the mid-1970's a company in Wyoming dissatisfied with its available legal entity choices decided that it would be useful to have a statutory business entity form that would provide all owners with limited liability while allowing the owners to be treated as partners for tax purposes. The result was the passage in 1977 of the Wyoming LLC Act, the first LLC act in the U.S.
The IRS determined the tax treatment of this new type of entity on a case-by-case basis. The Wyoming company that started it all applied to the IRS for a private ruling determining that the LLC would be taxed as a partnership. Eleven years later, the company finally received a favorable ruling. At the same time, the IRS issued Revenue Ruling 88-76, which spelled out the requirements for taxing an LLC as a partnership. With the issuance of Revenue Ruling 88-76 and the tax certainty it provided, the floodgates opened and an unprecedented torrent of new legislation issued forth. By 1996, every state in the U.S. had an LLC act. Legal and tax advisors scrambled to learn how to use this new entity.
Finally, in December 1996, the IRS issued the "Check-the-Box" regulations, which allows an LLC (or other entity) to choose whether to be taxed as a partnership or as a corporation. There are no hoops through which LLCs must jump for income tax purposes. Simply check a box or not. That's all it takes to choose the tax treatment of an LLC. With the advent of "Check-the-Box," the LLC is fast becoming the business, estate planning and asset protection entity of choice.
Although this section of our Web site discusses domestic asset protection
planning, offshore US-style LLCs are very similar to US LLCs, so they'll be
discussed here. Several offshore jurisdictions have LLC acts,
including:
Anguilla: Although many offshore jurisdictions had non-corporate limited liability entity statutes, none were very familiar to U.S. legal and tax practitioners. Sensing that the Wyoming-style LLC was going to be the future business entity of choice for Americans, a few offshore jurisdictions enacted U.S.-oriented LLC legislation. Anguilla adopted its LLC Act in 1994 and amended it in 1999. The Anguilla LLC Act was modeled on the Wyoming LLC act, which in 1994 was not one of the more modern U.S. LLC acts. The Anguilla LLC Act is also not favorable for use in estate planning. As a result, the Anguilla LLC is not often used.
Isle of Man: The Isle of Man adopted its LLC act in 1996. The Manx LLC act is modeled on Manx partnership law, which is, in turn, modeled on English partnership law. As a result, the Manx LLC act looks unlike U.S. LLC acts. In addition to being generally unfamiliar to U.S. persons and practitioners, the Manx LLC act has a number of provisions which many U.S. persons would find objectionable. Probably the most important of these objectionable provisions are that (1) Manx LLCs must have two or more members; and (2) Manx LLCs must keep certain accounting records in the Isle of Man.
Nevis: The Nevis LLC
Ordinance, enacted in 1995 and amended in 1999, is based on the Delaware LLC act. In 1995, the Nevis LLC Ordinance was perhaps the most advanced U.S.-style LLC act available to U.S. practitioners. Five years later, many U.S. states have taken drastic steps to improve their LLC statutes. The Nevis LLC Ordinance, however, is still one of the better LLC acts in existence. The Nevis LLC act was drafted to provide maximum flexibility, maximum estate planning advantages and maximum asset protection. In the offshore LLC world, the Nevis LLC Ordinance stands head and shoulders above other LLC acts.
Other Offshore LLC Acts: A few other jurisdictions have US-style LLC
legislation, including the Marshall Islands and Montserrat. The Cook Islands is expected to enact U.S.-style LLC legislation in the near future. It is likely that other jurisdictions will enact U.S.-style LLC legislation, promoting a healthy competitiveness to produce the most advanced cutting-edge LLC act in the offshore world.
Other offshore jurisdictions have European-style LLC acts or hybrid company acts (companies limited by stock and by guarantee, etc), including, for example, Barbados, Panama and the Cayman Islands. Many of these statutes (such as the handful of limited duration company (LDC) acts that were enacted) came into place or were amended only a year or two before the check-the-box regulations came into effect. With the advent of check-the-box in the foreign arena, many of these non-U.S.-style LLC acts are basically obsolete for U.S. purposes. Now, there is a wide range of foreign companies which can provide their owners with limited liability and passthrough taxation, and these are not just U.S.-style LLC acts. The Marshall Islands enacted U.S.-style LLC legislation in 1996, but like Anguilla's LLC act, it has not been much used because of the popularity and superiority of the Nevis LLC Ordinance.
There is an often overlooked but very important difference between being a shareholder of a corporation and a member of an LLC. The shares of a shareholder of a corporation are vulnerable to claims of the shareholder's judgment creditors. In many small businesses, this vulnerability could allow the creditor to control the business by getting the stock of a controlling shareholder.
The membership interests of an LLC are more protected. In the U.S. and in offshore jurisdictions with U.S.-style LLC acts, a creditor of a partner in a partnership or a member of an LLC is entitled only to a "charging order," rather than being entitled to execute directly against partnership assets. A charging order gives a creditor the right to receive any distributions that the owner of the interest would have received. A charging order is simply a court document that directs the manager(s) of the LLC to divert distributions that would otherwise go to the debtor member to the creditor to the extent of the unpaid judgment plus interest.
At first glance, the charging order may not seem like much protection. However, the economic rights to distributions are all that the creditor gets. The creditor does not get the management and voting rights that may go along with the LLC membership interest. The LLC's managers determine if and when distributions are made. It may be that distributions will not be made or that distributions will be significantly delayed. Some tax professionals believe that the creditor may be taxable on the debtor-member's income, even if the creditor never receives any distributions in respect of the charging order. This belief is suspect (see my article,
"Tax Consequences of Charging Orders: Is the KO by K-1 KO'd by the
Code?", Asset Protection Journal, Winter 1999), but the uncertainty in this area can make a creditor contemplating a charging order very uneasy. Furthermore, it may be possible to draft an LLC operating agreement to cause a creditor with a charging order to be taxable.
The charging order is not an attractive remedy to most creditors. As a result, the prospect of a charging order can often convince a creditor to settle on more reasonable terms than might otherwise be possible. Shareholders of a corporation have little such leverage. Thus, in addition to being a very useful business tool, the LLC can be a valuable asset protection tool.
The charging order derives from American partnership law which derives from English partnership law. Under partnership law as it existed toward the end of the 19th century, a creditor of a partner could execute directly against partnership assets to recover the debt of a partner which was unrelated to partnership business. This proved very disruptive to partnership businesses, and was perceived as unfair because non-debtor partners could do nothing to prevent the disruption.
Around the end of the 19th century, the English Parliament drastically changed English partnership law with the enactment of the Partnership Act 1890. The Parliament decided that it was, in fact, unfair to disrupt partnership business by having the sheriff seize partnership assets and selling them to satisfy a debt unrelated to the partnership's business. The Act provided that rather than obtaining a writ of execution against partnership assets to satisfy a judgment debt of a partner, a creditor of a partner must satisfy a judgment by obtaining an order from a court charging the partner's economic interest in partnership distributions of profits and capital.
When U.S. partnership law was being standardized in the early 20th century in the Uniform Partnership Act and later in the Uniform Limited Partnership Act, the charging order concept was imported into American partnership statutes. So, the charging order is well-established in the American law of partnerships and the concept now has been imported into American LLC law.
The single-member LLC is something of an anomaly since LLC law is largely based on the law of partnerships and, of course, there have never been single-member partnerships. There is nothing in any LLC act, foreign or domestic, that indicates that the charging order remedy is not the preferred or sole remedy available to a creditor of a member of a single-member LLC.
The original policy reason for the charging order, however, doesn't really exist with a single-member LLC. There is no other LLC member who would be unfairly affected by the seizure of LLC assets or of the LLC interest itself in its entirety.
It is the author's opinion that (1) a judge most likely would force a creditor of a member of a single-member LLC to pursue the charging order remedy before pursuing any other potential remedies; but that (2) the judge's patience in waiting for distributions in satisfaction of the judgment should be expected to wear thin very quickly; and that (3) the threat of further judgment enforcement action beyond a charging order would always linger over the debtor-member of the single-member LLC. Additionally, because single-member LLCs are likely to have fewer records documenting LLC business matters, it is likely that a debtor-member of a single-member LLC will have a harder time defending a claim that the LLC is the alter ego of its owner, and should be ignored altogether, obviating the need for a charging order altogether.
Therefore, if asset protection via the charging order concept is a major concern, single-member LLCs should be used with caution. When possible an additional member should be included to bolster the charging order protection. An additional member often can be added without changing the tax treatment of the LLC, e.g., by using a grantor trust or another LLC or IBC.
The members of a multi-member LLC should be well protected by the charging order in American courts. As noted above, the charging order has a long-established history in the U.S. Thus, even if a particular state's law required the application of its own LLC charging order law to the interest of a debtor member in an LLC formed under the law of another jurisdiction, the concept is neither alien nor out of line with the state's own public policy regarding the interest of a debtor member of an LLC. A debtor settlor of a foreign asset protection trust, on the other hand, will certainly be forced to wage battle against the long-standing public policy against self-settled spendthrift trusts in all U.S. jurisdictions except Alaska, Delaware, Rhode Island and Nevada.
Anguilla's LLC act provides for charging orders, but does not provide that the charging order is the exclusive remedy of a debtor of a member. Absent egregious circumstances, however, chances are probably slim that foreclosure would be quickly allowed.
The Isle of Man's LLC act does not provide for charging orders by statute. Apparently the drafters of the Manx LLC act intended that LLC members would rely on Manx common law to provide charging order protection LLC membership interests.
The Nevis LLC Ordinance provides for charging order protection. It also provides that the charging order is the exclusive remedy of a debtor of a member. No mention of foreclosure is made in the Nevis LLC Ordinance. It seems clear that the intent of the Nevis LLC Ordinance is to eliminate the possibility of foreclosure.
The favorable position of an LLC member from the standpoint of a fraudulent transfer challenge is another reason to consider the LLCs as an asset protection tool. The fact that the exchange of property for LLC interests is a transaction for valuable consideration can make an asset protection structure based on an offshore LLC preferable to a structure that requires the gratuitous transfer of a large amount of assets, such as the foreign asset protection trust. This fact can also mean, in some circumstances, that LLC-based asset protection structures can be set up at times when foreign asset protection trusts cannot, although very careful "badges of fraud" and solvency analyses must be made first.
Transfers for which valuable consideration is received are difficult to challenge under the fraudulent transfer laws of most jurisdictions, which require proof of a transferor's fraudulent intent to set aside a transfer. Transfers of property in exchange for pro rata LLC interests are impossible to challenge as fraudulent in those jurisdictions which require a showing that the transfer be without "equivalent value," regardless of the transferor's intent.
The use of offshore LLCs as asset protection tools has only become possible and practical in the last few years because of changes in U.S. tax law and the enactment of U.S.-style LLC legislation in Nevis. In the past, IBCs were popular asset protection tools (although their ultimate value as primary asset protection tools is questionable) to which for-value transfers could be made in exchange for IBC stock. However, the U.S. tax rules relating to gain recognition on contribution of appreciated assets to a controlled foreign corporation and the ongoing adverse income tax treatment made such planning painful from a tax standpoint.
Both domestic and foreign LLCs share advantages over trusts with regard to fraudulent transfer claims. Foreign LLCs have some additional advantages over domestic LLCs that help the members of foreign LLCs avoid some of the more common creditor attacks on domestic entities.
A creditor of a member of a U.S. LLC with a U.S. manager may be able to obtain a court order forcing the manager to make distributions which, combined with a charging order, will satisfy the member's judgment debt. The creditor of a member of an offshore LLC with a non-U.S. manager (e.g., a Bahamas IBC) in most cases will not be able to obtain jurisdiction in the U.S. over the non-U.S. manager. Even if an order were issued by a U.S. court, the non-U.S. manager could not be forced to comply unless and until a successful action was brought in the non-U.S. manager's jurisdiction. The uncertainty surrounding the choice of law issues and the potential for failure in a foreign jurisdiction create additional incentive for a creditor to settle on terms more favorable to the debtor LLC member than would otherwise be likely.
A creditor of a member of a U.S. LLC may also be able to obtain a court order dissolving the LLC, thus forcing out liquidation distributions which would, by virtue of a charging order, be diverted to the creditor to satisfy its judgment. A court in one U.S. state may or may not be able to order the dissolution of an LLC formed under the laws of another U.S. state, and if such an order was entered, it is unclear whether the courts of the state under whose laws the LLC was formed must give full faith and credit to the order.
These uncertainties do not exist with an offshore LLC. A U.S. court order purporting to dissolve a foreign LLC, such as a Nevis LLC, is not entitled to full faith and credit in the foreign jurisdiction. If a Nevis court did recognize such an order, absent egregious circumstances, it would be the end of the offshore services industry in Nevis. So, as a practical matter, it is highly unlikely that a Nevis court would enforce a U.S. court order purporting to dissolve a Nevis LLC.
Business owners conducting any type of business that has the potential for liability problems should consider using a Nevis LLC, with an offshore entity as manager, for its enhanced ability to provide limited liability protection to its owners for debts of the business to the extent that some assets of the LLC (e.g., working capital and equity stripped out of U.S.-situs property), can be held outside the U.S. in favorable jurisdictions that do not recognize U.S. judgments.
A judgment creditor of the LLC would be forced to bring an action, possibly even to re-try the case in its entirety, in each jurisdiction in which the assets were held in order to attempt to proceed against those assets. This would mean the creditor would be forced to spend the time and money necessary to pursue these additional court actions. And, the creditor would be forced to deal with foreign judicial systems, which may preclude punitive damages, forbid contingency fees for attorneys, and require the losing party to pay the legal fees of the winning party.
Domestic and foreign LLC law and the tax law applicable to LLCs has changed quickly (for the better) over the past decade. As a result, there is a great deal of old information about LLCs in circulation in print and on the Internet. For example:
The bottom line: buyers beware! If you're reading a free publication on the Internet, be very wary. You may get what you pay for.
A partnership is an association of two or more persons carrying on a business venture as co-owners for profit. Partnerships come in two basic varieties, general and limited.
A general partnership consists only of general partners. In a general partnership, the owners control the business and there is no statutorily mandated separation of ownership and management as there is in a corporation. Management of a general partnership is vested in all of the general partners. All partners of a general partnership are jointly and severally liable for the debts of the business and for the wrongful acts committed by other partners in the course of the partnership's business. Thus, the personal assets of a general partner are subject to the claims of the partnership's creditors.
A limited partnership consists of at least one general partner and at least one limited partner. The management and control of a limited partnership is vested in its general
partner(s) and cannot be vested in the limited partners. The liability of a general partner in a limited partnership is the same as in a general partnership. Whereas general partners have unlimited liability for debts of the limited partnership, limited partners have limited liability for debts of the partnership. However, a limited partner risks losing his limited liability if he participates in the management of the partnership's business.
A general partner (whether in a general partnership or a limited partnership) must obtain the consent of all the other partners to transfer his or her general partnership interest and grant to the transferee all of his rights as a partner in the partnership. Also, the death, retirement, bankruptcy or withdrawal of a general partner causes the partnership to dissolve. A partnership agreement may, however, alter these rules.
A limited partner may freely transfer his limited partnership interest without dissolving the partnership. However, such a transfer normally results only in a shift in the limited partner's economic rights in the partnership (rights to profits, losses, and liquidation proceeds), unless the general partners agree to treat the assignee as a substitute limited partner, and confer on the assignee all of the additional rights of a limited partner, such as the right to vote on non-management matters.
As an asset protection vehicle for personal asset protection (as opposed to business asset protection), limited partnerships work very much like LLCs as described above. Judgment creditors of partners (for debts unrelated to the partnership) generally are limited to a charging order against the debtor partner's interest in the partnership and cannot reach partnership assets directly.
A trust is a practical and flexible legal device by which one or more people you select (called your "trustees") manage assets for the benefit of others you designate (called your "beneficiaries"). Your estate planning attorney may recommend that you consider trusts for one or more purposes:
A trust can last for the lifetime of a beneficiary or can be designed to end when a beneficiary reaches a specified age. You can establish a trust either during your lifetime or in your will upon your death. What is commonly called a "living trust" is a revocable trust established during the lifetime of the grantor. A revocable trust is one that can be changed or revoked at any time before the grantor’s death.
Living trusts are very popular for several purported reasons, the most common of which is "probate avoidance." However, in most states, including in North Carolina, probate -- the court-supervised process of gathering your assets, paying your debts and distributing your assets to your intended beneficiaries under your will -- is not necessarily something to be avoided. The probate process protects your heirs and your executor. When assisting in the administration of an estate or trust, many law firms handle the legal services involved on an hourly fee basis, rather than having the fee based on a percentage of the estate or trust. This "percentage fee" is a common perception adding to the myth that a living trust saves a large amount of administration expense, which is probably not the case in most states. Some states, however, have laborious and expensive probate processes. Ask your estate planning attorney about your state if avoiding probate is really necessary.
Although many excellent attorneys advise their clients to use living trusts, living trust-based estate plans can be fraught with traps that can cause many unfortunate consequences. The most common problem is that assets are not transferred to the trust, which renders the trust useless as a probate avoidance vehicle. Other problems that can arise are the inadvertent loss of title insurance on real property transferred to trust, the inadvertent loss of property and casualty insurance on real and personal property transferred to trust, and the loss of certain creditor protection such as the protection provided to spouses who own property as tenants by the entirety.
Estate planning attorneys often suggest the creation of "irrevocable" lifetime trusts as a means of making gifts of property to family members or charities. It is common, for example, to put life insurance policies (and ultimately, their proceeds) in a special irrevocable lifetime trust called an irrevocable life insurance trust (ILIT).
Revocable trusts do nothing to protect assets (other than to provide a very thin layer of privacy in some cases). Irrevocable trusts, however, can protect assets. While irrevocable domestic trusts (other than, perhaps, the Alaska, etc. trusts described below) to which a grantor has transferred assets and also retained an interest cannot simultaneously protect assets transferred and the interest retained, they can protect assets if they are established for the benefit of third parties, such as spouses and children. The usual fraudulent transfer rules apply, i.e., a fraudulent transfer to a trust, no matter whom the beneficiaries, can be voided by a creditor and the assets used to satisfy a claims. However, once over the fraudulent transfer hump, assets in an irrevocable trust for third party beneficiaries can be protected from the grantor's creditors and from the beneficiaries' creditors, with proper trust drafting. Incorporating trusts into wills (these trusts are called "testamentary trusts") can provide a great deal of asset protection to beneficiaries while also providing flexibility and the benefits of ownership without exposing assets to creditors.
Alaska, Colorado, Delaware, Nevada & Rhode Island Trusts
Alaska, Colorado, Delaware, Nevada and Rhode Island have passed legislation in the last few years to change their trust laws to allow persons to establish trusts under the laws of their states which purport to have the same asset protection features as offshore asset protection trusts. That is, you can establish a trust in one of these states, name yourself as a discretionary beneficiary, and still have the assets in the trust protected from your creditors.
This is wonderful if you are a resident of one these four states and are
worried only about creditors from your own state. However, if you live and
work in, say, North Carolina, and you're sued in North Carolina, the judge will
likely apply North Carolina law regarding creditors' rights, rather than the law
of Alaska, Colorado, Delaware, Nevada or Rhode Island.
If the suit ends with a judgment against you in North Carolina, and the judgment
creditor is also able to establish that these kinds of asset protection trusts
are invalid in North Carolina and thus you should be treated as if you never
made the transfer, the "full faith and credit" provisions of the U.S.
Constitution would require an Alaskan court to enforce the judgment of the North
Carolina court, including requiring the Alaska trustee to cough up trust assets
to satisfy the judgment, since, according to the North Carolina judgment, the
trustee merely holds your assets as your agent, not as a trustee. There is
no such full faith and credit for U.S. judgments in offshore asset protection
jurisdictions. A creditor would be required to try his case anew in the
offshore jurisdiction.
Of course, the legal issues here are novel and are open to different interpretations. However, the most cautious course of action would be to avoid the uncertainties surrounding the efficacy of "onshore" asset protection trusts and to establish such trusts offshore. In other words, why take the risk?
For a similar take on this topic, see the September 8, 1997 Forbes Magazine article "Flimsy Shelters."
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